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Economic Substance Redux

The Court of Federal Claims ruled against another Son of BOSS
shelter, upholding penalties despite the taxpayers’ reliance on the
advice of tax attorneys

The Welles family owned Therma-Tru Corp., a leading manufacturer of
insulated doors. Between 1999 and 2000 the family negotiated the sale
of the corporation to a private equity firm for a $450 million taxable
gain. At the family’s request, its longtime attorney suggested they
employ a gain-sheltering strategy marketed by the law firm of Jenkins
& Gilchrist (J&G). That strategy would become known as Son of
BOSS (bond option sales strategy) and lead ultimately to J&G’s
demise. For other IRS victories against the shelter, see Jade
Trading LLC v. U.S. (101 AFTR2d 2008-1411, “Tax
Matters: Economic Substance Prevails Against Another Son of
BOSS,” JofA, March 08, page 71); also Brandon Ridge
Partners v. U.S. (100 AFTR2d 2007-5347, “Tax
Matters: Son of BOSS Goes Into Overtime,” JofA, Nov.
07, page 79).

This version, which the Welleses set up beginning in March 2000,
used foreign currency options plus a partnership termination to
increase the basis of the corporation’s stock. Five months later, the
IRS issued Notice 2000-44 that held such strategies lacked economic
substance. J&G and the family attorney’s firm decided the J&G
shelter was not similar to those in the notice, although notes made by
the family attorney indicate he was not convinced by their analysis.
The taxpayer paid more than $2 million in fees to J&G and more
than $1 million to the other law firm.

J&G provided the Welleses with a tax opinion letter stating that
the strategy should be effective. The government audited the
partnership tax return and denied the tax benefit and imposed
penalties. The taxpayer paid the tax and sued for a refund.

The Court of Federal Claims first determined that the strategy was
consistent with the Internal Revenue Code as it existed at the time
and rulings in Helmer v. Commissioner (TC Memo 1975-160) and
Coltec v. Commissioner (98 AFTR2d 2006- 5249).

Second, the court ruled Treas. Reg. § 1.752-6, issued in 2003, could
not be applied retroactively to deny the tax benefit. The regulation
provides that if a partnership assumes the liabilities of a partner,
the partner’s basis in the partnership is reduced by the amount of the
liability, but not below the value of the partnership interest. The
court also ruled that the regulation was interpretive and not
statutory. Thus, it was not entitled to Chevron deference
(Chevron USA Inc. v. Natural Resources Defense Council
Inc., 467 U.S. 837 (1984)) and could be applied retroactively
only in limited situations, the court said.

For a transaction to have economic substance, it must have a
reasonable possibility of profitability. The taxpayer’s experts
testified there had been a realistic possibility of a profit. But the
court sided with the government expert’s opposite view, saying the
taxpayer’s experts’ analysis was incomplete and in one case omitted
information that was contained in a preliminary report. On the other
hand, the government expert’s testimony was complete, used the
recognized Black-Scholes model and demonstrated the lack of profit
potential resulting from the high fee paid and the excessive price
charged for the options. The court also noted the attorneys’ fee was
based on the gain to be shielded, not the financial investment.

The court then upheld negligence penalties. Normally, the taxpayers
would have been able to avoid penalties, since they discussed this
issue with their regular attorneys as well as the law firm that
proposed the strategy. However, because the regular attorneys were to
receive one-third of the fee and brokered the strategy for J&G,
they were not independent and their advice could not be relied upon as
free from any conflict of interest, the court said.

The court then turned to the application of the economic substance
doctrine. In one version of the doctrine, the transaction will be
ignored if it lacks economic substance and was motivated solely by tax
avoidance. The other version will disregard the transaction if either
condition applies. The court applied the second version, based on the
Supreme Court’s decision in Frank Lyon Co. v. U.S. (41 AFTR2d 78-1142).

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